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KNET, INC. V. RUOCCO: Issuing Stock For Inadequate Consideration

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  • Posted on: Jan 5 2017

From time to time, this Blog has written about lawsuits involving corporations, including those brought as shareholder derivative actions (here). As this Blog explained,

a derivative action is a lawsuit brought by a shareholder of a company, on behalf, and for the benefit, of the company to enforce or defend a legal right or claim. Derivative actions seek the recovery of damages and/or equitable relief arising from unlawful or improper conduct engaged in by officers, directors, or other persons in control of the company.

The power of the derivative action is immeasurable. It allows a shareholder to compel changes in a company that otherwise might not happen, such as corporate governance reforms that strengthen and protect shareholder value, removal of officers or directors whose misconduct harmed the corporation, and monetary payments in the form of damages and/or disgorgement (repayment) of ill-gotten gains.

Although a shareholder has the derivative action in his/her arsenal, he/she cannot immediately run to court to redress an alleged wrongdoing. The shareholder must first formally demand the company’s board of directors act in the manner that the shareholder requires, such as suing the wrongdoers. The “demand” requirement, however, can be waived if the suing shareholder can show that such a demand would have been futile.

If the shareholder makes a demand on the board, then the board must be allowed time to determine the proper course of action to pursue. To assist it, the board will often seek outside counsel and/or create a committee of disinterested directors who were not involved in the transaction about which the shareholder is complaining. If the board and/or committee recommend legal action, then the board will likely file an action against the wrongdoers who have pursued, or are pursuing, the illegal or improper course of conduct. If, however, the board and/or the committee determine that legal action is not appropriate, then the demanding shareholder may commence an action for the benefit of the company.

A derivative action typically involves claims against an officer or director of the corporation, but can also include claims against others, such as outside accountants or advisors. Misconduct that can be addressed by a derivative action can include, among others, breach of the duties of loyalty, due care, and/or candor; fraud or other unlawful activity; self-dealing by insiders; conflict of interest; waste of corporate assets; improprieties related to executive compensation (including share ownership); and decisions that expose the company to harm or risk (e.g., violations of the law).

KNET, Inc. v. Ruocco: Consideration for The Issuance of Company Stock and The Board’s Business Judgment

On December 28, 2016, in KNET, Inc. v. Ruocco, 2016 NY Slip Op. 08853, the Appellate Division, Second Department, had the opportunity to consider a derivative action involving, among other things, the breach of fiduciary duty in connection with the issuance of stock to corporate insiders.

KNET arose from conduct that, according to the plaintiffs, caused losses, near ruin and harm to the corporate plaintiff, Interceptor Ignition Interlocks, Inc. (“Interceptor”). By their complaint, the plaintiffs, shareholders of Interceptor, sought the recovery of damages caused by one or more of the defendants’ breach of fiduciary duties, corporate waste, mismanagement, self-dealing, and engagement in conduct that contravenes the by-laws of Interceptor and the rights of its shareholders to participate in the management of its corporate business.

The Facts:

Interceptor was originally formed as Safe Start, Inc. in 2000 by the defendant, John Ruocco (“Ruocco”).  Ruocco had developed and patented a proprietary ignition interlock system for use in automobiles of drivers who had been convicted of driving under the influence of alcohol. Ruocco incorporated Safe Start to market and sell the device. In February 2007, Ruocco changed the name of the company to Interceptor, and amended the certificate of incorporation to provide that Ruocco was the owner of 500,000 of Interceptor’s 10,000,000 shares. At the time, the par value of Interceptor’s shares was $.001 per share.

In May 2007, Interceptor issued 1,500,000 shares of company stock to Rosemarie Sylvester (“Sylvester”), Ruocco’s sister and a defendant in the action, as well as to himself. Three years later, in May 2010, Ruocco and Sylvester were each issued 2,500,000 shares of Interceptor stock, for a total of 4,000,000 shares each. Interceptor also issued shares to outside investors, pursuant to subscription agreements, at $2 per share.

In June 2010, Interceptor entered into a business development agreement and a consulting agreement with the plaintiff, KNET, Inc. (“KNET”), a company owned by the plaintiff Gary Melius (“Melius”). These agreements allowed KNET to earn shares of Interceptor at par value if KNET performed certain services for Interceptor. Pursuant to the agreements, KNET would earn 2,803,214 shares of Interceptor stock upon the enactment of a state or federal law requiring the use of Interceptor’s device, 934,405 shares for introducing Interceptor to one or more public officials and one or more automobile insurers, 934,405 shares upon Interceptor being certified in at least one state where it was not yet certified, and 3,176,976 shares upon securing financing for Interceptor “in the minimum amount” set by Interceptor. In November 2010, the financing provision of the consulting agreement was amended, in pertinent part, to provide that if Interceptor received a loan of $1,500,000 from Flushing Savings Bank, KNET would receive 5% of the outstanding shares of Interceptor.

The Motion Court Proceedings:

In 2013, Melius, as principal of KNET, and Thomas Grogan, the owner of 57,500 shares of Interceptor stock, filed a derivative complaint against Ruocco and Sylvester, alleging, among other things, that Interceptor issued shares to Ruocco and his family members without adequate consideration, resulting in at least $10,000,000 in damages.

Following proceedings involving a request for injunctive relief, the plaintiffs moved for summary judgment on their claim to invalidate the shares of Interceptor stock that Ruocco and Sylvester had issued years before for allegedly little or no consideration, to enjoin them from voting those shares, and to determine the number of shares of Interceptor held by KNET.

By order dated December 24, 2013, the Supreme Court, granted the plaintiffs’ motion. In doing so, among other things, the court invalidated all but 500,000 shares of Interceptor stock issued to Ruocco and all of the shares of Interceptor stock issued to Sylvester “based upon defendants’ undisputed failure to provide sufficient consideration for their shares.” Slip op. at 2. Under New York law, “directors of a corporation cannot issue or dispose of the corporate stock to themselves for an inadequate consideration.” Id. (citation omitted). The reason being, directors “owe a fiduciary responsibility to the shareholders in general and to individual shareholders in particular to treat all shareholders fairly and evenly.” Id. (internal quotation and citation omitted). Therefore, a director breaches that duty when he/she issues new stock for no or inadequate consideration. Id.  (citations omitted).

In pertinent part, the court found:

The record demonstrates that defendants’ shares were improperly issued and issued without sufficient consideration. Once Ruocco … accepted $50,000 for 25,000 shares …  he could no longer treat Interceptor as his own personal property and thereafter issue to himself or his sister shares for either no or minimal consideration.

* **

Here, 5 million shares were issued in 2010 for no consideration and reliance cannot be made to the claimed October 31, 2006 transfer of funds to which no nexus is shown of an intended purchase of stock. In any event, the inadequate price is demonstrated by the sale of stock for two dollars a share, when defendants claim that on the very next day, they acquired shares for a pittance.

* **

No legitimate business purpose was offered supporting the issuance of stock to the defendants at the price claimed, nor was the claim made that the price they paid a fair one.

Id. at 13, 14 (internal quotations and citations omitted).

The Second Department Ruling:

Citing to New York’s Business Corporations Law and the business judgment rule, the Second Department reversed the Supreme Court’s grant of summary judgment, finding issues of fact for the trier of fact to resolve.

With respect to the contention that Ruocco and Sylvester were improperly issued shares in Interceptor, consideration for shares may consist of “money or other property, tangible or intangible; labor or services actually received by or performed for the corporation for its benefit or in its formation . . . In the absence of fraud in the transaction, the judgment of the board or shareholders, as the case may be, as to the value of the consideration received for shares shall be conclusive” (Business Corporations Law § 504[a]). Here, issues of fact exist as to whether Ruocco and Sylvester were improperly issued shares in Interceptor since the parties’ submissions indicate that Ruocco was the founder of the corporation and performed services in the formation of Interceptor (see Matter of Heisler v Gingras, 90 NY2d 682, 687), that Ruocco and Sylvester invested in the company, and that Sylvester’s  shares may have been a gift from Ruocco. [Emphasis added.]

Slip op. at 3.

Takeway:

KNET teaches two important lessons.  First, as set forth in New York statutory law, consideration for the issuance of shares comes in all forms. Business Corporations Law § 504[a]. Money is not the only form of consideration.

Second, the business judgment of the board of directors cannot be easily disturbed absent fraud, waste, a breach of fiduciary duty or bad faith. The “business judgment rule” presumes that the directors of a corporation will act in the corporation’s best interests. Thus, if a plaintiff sues a company’s officers or directors for breaching a fiduciary duty, he/she will have to show that the officers or directors were not acting in the best interests of the company and that they failed to meet their duties of loyalty, care, or good faith. As the plaintiffs in KNET learned, if they are to succeed, they will have to prove that Ruocco caused Interceptor to issue company stock for little or no value in violation of Business Corporations Law § 504[a] – that is, he breached his fiduciary duties to the company and its shareholders.

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